Hello and welcome to Financial Face-off, a MarketWatch column where we help you weigh financial decisions. Our columnist will give her verdict. Tell us whether you think she’s right in the comments. And please share your suggestions for future Financial Face-off columns.
Markets have been tanking, with the S&P 500 SPX, -2.81% recently dipping into bear territory and the Dow Jones Industrial Average DJIA, -2.01% sliding 9% this year as of this writing. But if you’ve got savings in a traditional individual retirement account, there can be a potential upside to shedding all that value. Depending on your individual financial situation, market downturns like this can create the ideal conditions for a Roth IRA conversion, when you move money from a traditional IRA into a Roth IRA.
So is now a good time for you to do a Roth IRA conversion, or not?
Why it matters
A Roth IRA represents a rarity in U.S. tax law. “There are very few instances in the tax code where you can invest in something that is going to grow and it’s going to be tax-free when you take it out,” said Greg Plechner, a partner and wealth manager at Greenspring Advisors in Paramus, N.J.
Traditional IRAs are funded with “pretax” dollars, meaning you won’t owe taxes on the money that you put into an IRA in the year that you contribute the money. But you will have to pay taxes on withdrawals that you take from a traditional IRA, which you’ll be required to make starting at age 72.
With a Roth IRA, however, you pay taxes on the money when it goes into the account, and you don’t have to pay taxes when you start pulling it out of the account — if you follow the rules. You can start withdrawing the amount you’ve contributed to a Roth IRA (but not the investment earnings or the conversions) any time, but there are penalties and taxes if you do it sooner than five years after setting up the account and before turning 59½ years old. (There are exceptions if you’re using the money to buy a first home or have a child.)
Converting a traditional IRA to a Roth IRA makes sense if you anticipate that your personal tax rates will increase in the future. A Roth conversion is attractive when markets are down because if your account has lost value, you’ll pay less tax on the conversion. The value will bounce back over time (hopefully) and that growth will be tax-free.
“Let’s say you had $100,000 in an IRA invested in stocks. It’s now down to $80,000. If you can move that $80,000 into a Roth, you’ll only pay tax on the $80,000 and then move it into a Roth where it can hopefully grow back to $100,000 or more, which would all be completely tax-free growth,” said Grant Meyer, a certified financial planner and founder of GTS Financial in Bloomington, Minn.
Which brings up an important point: The money you pull out of your traditional IRA and convert to a Roth is taxable. It shows up as income on the front page of your tax return. That additional income can have serious financial consequences, such as pushing you into a higher tax bracket. If you’re receiving Social Security retirement benefits, it can effectively lower your benefits by potentially increasing their taxability. If you’re of Medicare age, the additional income can increase the monthly surcharge you may owe on top of your Medicare Part B premiums. The extra income may also expose you to the 3.8% Medicare surtax that higher earners pay.
Given those potential nasty side effects, when it comes to Roth conversions, “small is your friend,” Plechner says. “Don’t go crazy.” One prudent strategy is to do a partial conversion. Keep a watchful eye on which tax bracket you’re bumping into with a technique called “filling the brackets,” he suggested.
It depends on your situation, but given the market downturn, it seems like a good time to strongly consider a Roth conversion.
That’s especially true if you’re in what Meyer calls “the holy grail” situation. By that, he means someone whose income is low and is therefore in a lower tax bracket, has enough cash to pay off the tax bill on the conversion, and has taken some hits in the markets.
Let’s say you’re a young person who built up some cash due to stimulus payments, and invested heavily in tech because it was doing well. “There’s probably a lot of people like that whose portfolios are down,” Meyer said.
“They’re a great candidate” for a Roth conversion, he said, especially because, if they’re younger, they wouldn’t have to worry about the potential Social Security and Medicare fallout. Early retirees, people who have lost their jobs or at least some of their incomes or workers taking a year off from the labor market may also be good candidates, as their income is theoretically lower.
While we can’t predict future tax rates, there’s evidence to suggest that they’ll go up, which makes a Roth conversion all the more attractive. Tax rates are at historic lows, there appears to be more of an appetite for taxing the wealthiest, and many of the lower rates created by the 2017 Tax Cuts and Jobs Act will expire in 2025. “I think we could very easily see some sort of tax rate increase on the upper levels,” Meyer said.
Is my verdict best for you?
On the other hand, if you’re in the top three marginal tax brackets, the advantages of a Roth conversion are diminished, Plechner said. “If you make over $170,000 and you’re single, you’re now in the 32% bracket. That’s my upper limit of where I would be comfortable doing a Roth conversion.”
Another factor to take into account is what state you live in, says Plechner. If you’re in New York and planning a move to Florida, where there’s no state income tax, wait until you’re in Florida to do a Roth conversion so you can skip paying the state tax bill on it.
Here’s another big caveat: Roth conversions are irreversible (that’s been the case since the Tax Cuts and Jobs Act went into effect). If you get really aggressive and convert $100,000 and the tax bill comes in April and you don’t have the money, you’re stuck, Meyer said.
“Once you do this you cannot go back,” Meyer said. “That is why doing your homework up front is imperative because there’s no undo switch.” Don’t go down this road unless you’re clear on what your income for the year will be and what tax bracket you’re in.
Tell us in the comments which option should win in this Financial Face-off. If you have ideas for future Financial Face-off columns, send me an email.